Mean Streets at Urban Outfitters

As investors fret over the state of the consumer, many retail stocks have come to look like fashion casualties. One retail stock that has borne the brunt of a difficult first half of the year has been Urban Outfitters (Nasdaq: URBN) . I should know; I'm a shareholder, too, and the pain has been protracted.

Urban Outfitters' performance is especially painful for me because I recommended the stock as my pick for The Motley Fool's Stocks 2006 report. It's nothing short of excruciating to see that the stock is down more than 50% since then.

But when it comes to punishing Urban Outfitters, I think investors are overdoing it by a long shot. It's true that Urban Outfitters was priced high for growth, and it's important for investors to learn that the slightest problem can set off an avalanche for such stocks. In fact, that's one of the risks I mentioned in my Stocks 2006 piece. On the other hand, another good lesson to remember is that when investor sentiment turns ugly on a stock, as has happened with Urban Outfitters, the lows can go too low.

Although I can understand why some investors might be tempted by the conventional wisdom and wonder whether this stock's a dog, I'd argue that investors have punished this stock far too harshly for the circumstances, and that it's still a great component for long-term portfolios.

Panic in the streetsUrban Outfitters' shareholders are used to a company that consistently drums up torrid growth. It had the premium share price to prove it. Then, last winter, Urban Outfitters explained that a "seismic shift" in fashion was taking place, and that translated into the first "miss" I can recall from the retailer.

The shift in question was a rebirth of '80s-inspired fashions -- think oversized, smocky blouses and tight jeans, pants, and skirts. Think leggings. You get the picture. In a strange turn of events, it seems that Urban Outfitters actually got the new look into its stores too quickly, and many shoppers balked. No surprise there, if you ask me. I can't say I'm thrilled that fashionistas have decided to bring back what I consider to be one of the most unpleasant periods in fashion history -- let's hope shoulder pads aren't coming back, too! -- and I have to wonder how many people feel the same.

Take a look at last quarter's earnings. Nobody likes to see a retailer they own have to mark down their merchandise, but Urban Outfitters had to move its inventory as shoppers turned their noses up at its "forward-looking" fare.

I suspect that Urban Outfitters has been doubly punished. It's also feeling the effects of macroeconomic concerns -- the housing boom's bust, inflation fears, and the high price of gasoline. Another historical highflier and traditionally excellent performer, Chico's (NYSE: CHS) , has also been getting knocked around, so it seems that investors have simply lost faith in many retailers these days.

However, worrying about whether consumers are going to pare down their expenditures in the short term is different from worrying about whether a company's business is flawed for the long haul. I argue that Urban Outfitters' brand ain't broken.

Urban Outfitters vs. GapWith fewer than 200 stores, including its Anthropologie and Free People chains, Urban Outfitters has plenty of room for growth. It's also got $174.8 million in cash and short-term investments on its balance sheet, and no debt.

It has a real sustainable competitive advantage related to the types of hipsters and bohemians it caters to; its retail concepts appeal to individualist aspirations that work well for lifestyle brands. I'd argue that Urban Outfitters doesn't have a slew of large, clear-cut competitors offering similar items, the way many other youth-oriented retailers do. And despite similar names, it doesn't actually compete with Citi Trends (Nasdaq: CITI) , a stock to which I've seen it compared at times.

I also don't believe that Urban Outfitters' brand has been harmed for the long term. Those of you who have read my articles before know that there's another stock I feel differently about -- after several years of flubbed sales, I fear that Gap (NYSE: GPS) might be in danger of permanent brand damage.

Urban Outfitters has been a strong performer over the years, and it still exhibits more growth than many other retailers do, even with its current challenges. When I consider the prices on Gap and Urban Outfitters, I'm struck by the discrepancy between the companies' respective problems, and how badly investors have chosen to punish each stock. Urban Outfitters' shares have been nailed to the tune of 54% in the past 12 months.

Given the short time frame we're dealing with, there's no proof that Urban Outfitters' merchandising problems aren't temporary, and its sales, in the double-digit range, remain strong. An important caveat, of course, is that discounting its wares has weakened its historically strong margins. We're looking for Urban Outfitters to boost its margins again -- and we're hoping its merchandise issues improve sooner rather than later.

On the other hand, Gap has been struggling for years now, to the point at which a P/E of 14 simply sounds too pricey to some of us who aren't quite sold on the idea of an imminent turnaround.

Urban Outfitters' P/E of 20, on the other hand, looks downright appealing, since it still has so much growth left in it. If you look at its historical average P/E, it hasn't been this low for two and a half years. Meanwhile, even though analysts expect little growth this year, earnings in fiscal 2007 and 2008 are expected to increase by about 20% to 30%, which is interesting, given the company's current forward P/E of a mere 14. That's where you begin to wonder whether investors have simply punished Urban Outfitters far too stringently. Hitting a tricky fashion trend too soon is not the unforgivable offense for shoppers that it apparently is for Wall Street; I'd be more worried about a retailer missing new trends altogether, for an extended period of time.

What's more, Urban Outfitters' market cap is a $2.38 billion, while Gap's is a whopping $14 billion. Again, Urban Outfitters has room to run. Gap's a mature retailer, with more than 3,000 stores, and it has its work cut out for it -- not only in jump-starting sales at its existing concept, but also in coming up with new concepts and new markets to lure customers. In comparison, Urban Outfitters hasn't even needed splashy TV advertising campaigns to get scenesters in its stores.

Sweating the short term is so uncoolA significant portion of my investment thesis has always been that Urban Outfitters has smart, engaged management. Co-founder and President Richard Hayne is still at the helm, and according to the company's most recent proxy statement, he owns a sizeable 30% of the stock -- a hefty stake that gives me even more faith that Urban Outfitters is well-positioned for the long term. In contrast, Paul Pressler's Gap ownership is negligible, despite his history of large salaries and stock options.

Of course, we'll all find out more once Urban Outfitters reports its next quarterly earnings on Aug. 10. With all of the fears that consumers are paring down spending, I wouldn't be too surprised if it's another tough quarter. As a matter of fact, Urban Outfitters gave us a preview today with a release of second-quarter sales figures -- overall sales are up only 13%, and same-store sales are down 7%. However, the company did say that it's getting a better handle on what its customers are responding to.

Regardless of the short-term problems, I still believe that Urban Outfitters is one of the best-positioned companies in its market for years to come. Despite all of the pessimism, maybe the current climate and a difficult shift in fashion have offered one of the few opportunities to get this stock on sale.

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